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US Leverage requirement is credit positive for banks

by William Arnold | Jul 17, 2013

Last Tuesday, US regulators and law makers issued a notice of proposed rulemaking that would increase and enhance the minimum Tier 1 leverage ratio requirement for US banks that have been designated as global systemically important banks (G-SIBs). This proposal is credit positive because the leverage ratio provides a balance and enhances the risk-weighted capital adequacy measures by limiting banks’ ability to leverage up on perceived “low risk” assets that at a later date may contain high unexpected losses. In addition, since most of the banks do not currently meet the new minimums, the proposal will require banks to increase their capital or reduce assets in order to comply by the 2018 final implementation date.

The eight US G-SIB banks are: Citigroup Inc, JPMorgan Chase & Co, Bank of America Corp, The Bank of New York Mellon Corp, The Goldman Sachs Group, Morgan Stanley, State Street Corp and Wells Fargo & Company.

The leverage ratio is a simple and transparent measurement of capital adequacy that complements risk-weighted capital adequacy measurements. Risk-weighted measurements attempt to differentiate the risk of asset classes, requiring banks with higher-risk assets to hold more capital. In isolation, the risk-weighted capital approach can lead to banks reporting satisfactory capital ratios even though they are highly leveraged to low-risk assets. The approach also can allow banks’ management to arbitrage the risk-weighted capital rules, which are a product of modelling and underlying assumptions that lack transparency and are subject to manipulation, in order to optimise capital and return measurements.

Because the supplemental leverage ratio does not attempt to determine the loss content or differentiate risk between asset classes, it provides a check to risk-weighted capital ratios in that the use of adjusted average balance sheet assets and off-balance-sheet exposures help to ensure that banks have cushions for unexpected losses. Meanwhile, the existence of risk-weighted capital measurements helps to discourage banks from holding only high-risk assets.

US regulators have already adopted a minimum supplementary leverage ratio of 3%, consistent with Basel III. However, the US has long had a leverage ratio that prevented the major US banks from being as leveraged as some major European banks. This latest proposal would require that the eight US bank holding companies and their insured depository institutions maintain supplementary leverage ratios of 5% and 6%, respectively.

The supplementary leverage ratio differs from the current Tier 1 leverage ratio in that the denominator includes off-balance-sheet exposures. The proposal estimates that the supplemental approach increases leverage exposure by 43%, meaning that to maintain the same leverage ratio as under the current approach, the average company would have to hold 43% more capital. In addition, the proposal notes that if the 5% minimum were in effect as of third-quarter 2012, the covered holding companies that did not already meet the minimum would need to increase their Tier 1 capital by approximately $63bn. This amount is quite manageable given that the proposed effective date is 1 January 2018 and that the banks could easily meet this requirement through retained earnings.